A customer of an insurance company or a reinsurance company pays the (re)insurance company a premium to bind a (re)insurance policy for the customer. The (re)insurance policy allows the customer to make a claim against the (re)insurance company for a covered amount when the customer suffers a loss covered by the (re)insurance policy. The (re)insurance company is generally required by law or insurance regulation to keep a certain amount of the premium payment available to pay anticipated losses. These funds that are set aside to pay later losses are referred to as loss reserves.
(Re)insurance companies may also hedge their risk on a (re)insurance policy by using other financial instruments related to the entire (re)insurance industry, such as CAT bonds or industry loss warranties (“ILWs”). These industry-based or index-based securities generally use industry losses as a trigger mechanism for payout of a specified amount of money to a (re)insurance company or other insured entity. It is noted that throughout this description when the term “security” or “securities” is used it refers to the reinsurance or ILW instruments, which may or may not be a security as that term is defined by law. An ILW contract is a manner through which one party will purchase protection based on the total loss arising from an event or series of events to the entire (re)insurance industry rather than its individual loss. The maximum amount of protection offered by the contract is referred to as the “limit.” The industry loss threshold whose exceedance results in a payment under the contract for as much as the limit is referred to as the “trigger.” To provide a specific example, an insurance company may purchase a contract having a limit of $200 million that is payable upon an industry loss event of $25 billion (the trigger). That is, if an event occurs (e.g., an earthquake) where the total industry loss exceeds $25 billion, the insurance company will receive a payment up to a limit of $200 million, regardless of actual losses suffered by the insurance company during the event.
However, there are no effective instruments that are offered to hedge an insurance company's risk for casualty lines of business based on systemic risks, e.g., those risks that are of, relating to, or common to the entire system and experienced across and entire line of business or the entire industry. An example of systemic risk is aggregation risk, which is an exposure concentration affecting similar types of risks or a particular coverage involving multiple accident years arising out of a particular product, substance or some common causative factor such as a design, business activity, error or omission. Other examples of systemic risk include a new legal theory, a new coverage interpretation, liability arising out of a relatively new or existing product or technology, changes in the macroeconomic conditions (e.g., medical inflation driven by a costly new technology or unforeseen cost shifts associated with universal health insurance), changes in the regulatory environment or other unforeseen causes that affect the entire industry.
There are several reasons that these security products do not exist to deal with systemic risk, including moral hazard (e.g., the hazard associated with the individual company's ability to manipulate reserves), high capital charges associated with the long tailed (slow to settle) lines of business (make it uneconomic for reinsurers to write), and significant underwriting expense and due diligence and market reservations to write casualty due to external factors including social, economic and political influences.